Friday, February 18, 2011

• Banks begin reporting first quarter earnings with Canadian Imperial Bank of Commerce (CM) and National Bank (NA) on February 24, followed by Bank of Montreal (BMO) on March 1, Canadian Western (CWB) (after market close) on March 2, Royal Bank (RY) and Toronto-Dominion (TD) on March 3, Bank of Nova Scotia (BNS) on March 8, and Laurentian Bank (LB) closing out reporting on March 9.

• We expect first quarter operating earnings to increase 3% year over year (YOY) and 8% sequentially (more normalized expense levels). We expect wholesale banking earnings to be solid on a sequential basis but well below the exceptionally strong earnings from a year earlier. This quarter, wholesale earnings are expected to be driven by strong underwriting and advisory revenue partially offsetting weak fixed income trading revenue. Retail banking earnings growth is expected to begin to slow but to remain resilient with double-digit growth. Wealth management earnings are expected to continue to show strong momentum, the strongest of any of the business lines. International for BNS and TD is expected to be strong, with continued weakness at RY and BMO.

• Earnings growth YOY is expected to be led by BMO, BNS, and NA at 15%, 13%, and 8%, respectively. TD and RY have very challenging comps with earnings declines of 3% and 5% expected, respectively. CM, LB, and CWB earnings growth is expected to be modest at 3%, 3%, and 0%, respectively.

• Bank earnings recovery/growth has been a grind this cycle thus far as earnings growth in 2010 was anaemic due to the countercyclical high wholesale earnings in 2009. In fiscal 2010, TD, and NA have had the strongest earnings recovery at plus 1% and 0% versus peak earnings, with BNS 3% below peak. CM, RY, and BMO are significantly below peak earnings at 27%, 17%, and 16%, respectively, due mainly to lower wholesale earnings and perhaps capital allocation issues.

• We believe dividend increases are again possible this quarter, following up on dividend increases by NA, LB, and CWB last quarter. TD is the most obvious candidate for a dividend increase, followed by BNS. We expect TD to increase its annual dividend 6.6% to $2.60 per share this quarter. BNS, although less likely in our view, could increase its annual dividend 6.1% to $2.08 per share. Further dividend increases by NA, LB, and CWB are also possible mid-year, if not very large ones in the fourth quarter. The banks' payout ratios and quarterly dividend trends are highlighted in Exhibit 6.

• The most significant earnings variable this quarter remains the net interest margin, particularly the retail net interest margin. Stability in the margin is critical to drive revenue growth, especially in light of the countercyclical slowdown expected in consumer and mortgage loan growth. We expect a stable to expanding margin based mainly on the expectation of higher interest rates, which we believe will fully offset competitive pressures driven by slowing volume growth. We expect the oligopoly pricing structure to hold.

• The banks’ overall net interest margin has many cross-currents with average BA rates up 11 bp sequentially; however, the yield curve actually steepened modestly sequentially, although still substantially flatter than a year earlier. The positive impact of higher short-term interest rates, we believe, is still filtering through, helping offset competitive pricing pressures. The residential mortgage GIC spread (posted) continued to decline in the quarter in both the one and five-year term. The caveat is that drawer rates have become more of a factor in the past 10 years; nevertheless, this remains a concern.

• Canadian banks' Investment Banking Division/Wholesale earnings in Q1/11 are expected to increase 10% quarter over quarter (QOQ) but decline 25% YOY based mainly on lower trading revenue. Trading revenue in Q1/11 is expected to decline 8% QOQ and decline 31% YOY to $1.9 billion due mainly to weaker fixed income trading results. Underwriting and advisory revenue is expected to increase slightly YOY and 4% sequentially.

provisions are expected to continue to decline with improvements moderating. We expect a modest 4% sequential decline in provisions.

• International earnings are expected to improve, aided by the lower drag from the high C$, especially for BNS and TD with their solid operating earnings base. The C$ has appreciated 5% YOY in Q1/11 vs. 4% YOY in Q4/10 and a peak of 21% YOY in Q2/10. The C$ appreciation QOQ is only 3% and we expect the C$ drag to be de minimis going forward.

• Bank profitability this quarter is expected to remain solid, although with a lower return on equity at 16.4% (see Exhibit 12) due to continued wholesale banking weakness, net interest margin pressure, and deleveraging. However, on a RRWA basis, profitability is expected to be near record highs at 2.24% (see Exhibit 13).

• Bank earnings beat Street expectations for most of fiscal 2009 and the first quarter of 2010. However, banks missed earnings expectations the past three quarters (Q2/10, Q3/10, Q4/10). Earnings expectations have now been toned down, especially with respect to capital market or wholesale earnings, thus we would expect banks to meet expectations with some beat possibilities as we progress through 2011.

• The one trend that remains solidly intact is balance sheets continuing to strengthen. We expect capital levels to continue to build based on internally generated capital and management of risk-weighted assets. Balance sheet strength and solid earnings are expected to position the bank group for further dividend increases.

• Bank disclosure on the impact of Basel III is critical as we move through 2011. We are hopeful that banks begin to release pro forma Tier 1 common calculations or a part thereof as early as this quarter, which will provide the necessary clarity that the market is looking for. “Clarity on Capital” is one of the themes we have cited for 2011. This is in addition to the other 2011 themes: “Return to Operating Normalcy,” “Dividend Increases,” “Moderation of Fears about Consumer Debt and House Prices” (see report titled Bank Index Poised to Hit New All-Time High).

Valuations Attractive – High Dividend Yield

• Bank valuations remain very attractive with a dividend yield of 3.6%, which is 102% of the 10-year bond yield and 158% of the TSX dividend yield versus historical means of 59% and 145%, respectively. The bank earnings yield relative to corporate bond yields is 150% versus the historical mean of 131%.

• Bank dividend yield relative to Pipes and Utilities and REITs are also very attractive at 0.4 and 1.4 standard deviations above the historical mean, respectively.

• Bank P/E multiples, we believe, are attractive at 12.7x and 11.3x our 2011 and 2012 earnings estimates and are poised for expansion. Basel III goal is to lower systemic risk, which we believe will ultimately result in a lower risk premium or higher P/E multiples. The resumption of dividend growth is expected to be a further catalyst for higher P/E multiples.

Reiterate Overweight – Bank Index Poised to Hit New All-Time High

• Bank share price performance continues to be resilient despite the hot resource market, with the bank group outperforming early in 2011, which is a very positive sign. January mutual fund data also is bullish for banks stocks as Fixed Income inflows plummeted and banks, we believe, are the premier dividend/income play in the equity markets in Canada.

• We recently boosted our bank share price targets 8% for a total expected return of 22% over the next 12 months. Stock splits may soon be on the horizon. Our new target prices are based on a target P/E multiple of 15.2x our 2011 earnings estimates versus our previous target of 13.9x. Our new target multiple is similar to the highs reached in 2006, which we considered late cycle. We believe we are early cycle in 2011 and earnings growth visibility will improve in 2011.

• Thus, in our view, the beginning of a great decade for bank share price performance. The theme for the decade is expected to be “Generation of Surplus Capital, Capital Deployment, and Share Repurchases.” Share repurchases have never occurred of any consequence in Canadian banking.

• Canadian banks did not repurchase shares between 1967 and 1994. Share repurchases from 1995 to 2010 were insignificant, averaging only 1.0% of shares outstanding, with the highest year being 2.3% of shares outstanding. Bank share repurchases hype over the past 10 years was not matched by actual activity. Thus, the market did not differentiate much between individual bank capital levels or capital generation ability (RRWA). Capital deployment with a focus on share repurchases and RRWA (new profitability paradigm) are expected to be the themes of the next decade, supporting the expected continuation of the bank group’s long term outperformance.

• Bank stocks have substantially outperformed the market since 1967, we believe, because the market underestimates the sustainable earnings power and growth of the sector (barriers to entry and strategic industry) and is slow to attribute an appropriate multiple to reflect the fundamentals, profitability, and structural changes that have occurred in the industry. We expect long-term outperformance to continue and this could be one of the banks’ best decades for absolute and relative share price performance.

• We believe bank fundamentals are strong and valuations are attractive. We reiterate our overweight recommendation and we would have no sells in the group on an absolute return basis. TD Bank is our top pick in the sector. We have 1-Sector Outperforms on TD, CM, NA, and CWB, with 2-Sector Performs on LB, BNS, RY, and BMO.